Gnosis, a blockchain-based project creating a prediction network, recently raised £10.5m in 12 minutes. There wasn’t a single investment banker involved. An uptick in such news has begun to attract more attention around the world.
Any introductory Corporate Finance textbook will tell you that there are only two ways for a company to raise money (i.e capital) from investors. The first way is to sell some sort of ownership stake in the company. This is called equity capital. The second way is to borrow money and pay it back over time with interest. This is called debt capital. As long as businesses have existed and have needed capital, their only options have been variations of debt or equity. Recently, a small number of businesses have been exploring a new option – cryptocurrencies.
What Is a Cryptocurrency?
In very general terms, a cryptocurrency is a decentralised, digital currency which is exchanged and transacted through a peer-to-peer network. Bitcoin, the first cryptocurrency created in 2009, is now very well known around the world and a Bitcoin is now worth over £1200. Since Bitcoin, over 700 different cryptocurrencies have sprung into existence, with four crossing the $1bn market capitalisation mark. In fact, the underlying blockchain technology has attracted even more attention for its potential to disrupt many industries from healthcare to electronic voting.
Initial Coin Offering
One of the developing innovations of this movement is a new way for businesses to raise capital. It’s been termed as an Initial Coin Offering (ICO).
How does an ICO work? When a firm wants to raise money (usually at the beginning stages), it creates a ‘whitepaper’ listing out what their project is about, the technical details, funding requirements and how much of the cryptocurrency (or token) will be sold to the public. Then during the ICO, investors and enthusiasts buy the distributed amount of the cryptocurrency.
Think of it like a group of people moving to an uninhabited island. But, to join this new island you must buy the newly issued currency of the island. This new currency is needed to facilitate the functioning of the island. But, it’s also needed to initially set-up the island and get the project off the ground. The people who buy the new currency get the benefits of living on this new island, and they hope that in the future more people want to join this island and the currency gains value. This is the premise of an ICO.
Buying a token in an ICO neither confers ownership of the project nor does it promise any payments, making it a new kind of security. People invest in tokens for two main reasons. The non-financial reason is that many investors tend to also be great enthusiasts of the project and want to see the technology succeed. But, the potential of incredible returns is the key driver of these investments. For example, a person who would’ve bought £100 of Ether at the time of their ICO in 2014, would now have earned a whopping £20,000 in 3 years. The appeal is not that hard to see.
According to Blockchain researcher Smith & Crown, about £210m was raised last year from coin offerings. So far in 2017, 60 ICOs have been scheduled, and £95m has already been raised from the 30 ICOs that have been completed.
ICOs have proven to be very useful for start-ups. The process is quick and time efficient. Firms usually deal with many small investors rather than a few large ones granting the firm more freedom. But the real clincher is that the firm gives up neither control nor their precious cash flow. It almost sounds like a free lunch for the firm.
However, there are some significant drawbacks. For investors, apart from the large amount of risk that the project will fail, there’s also a real danger of becoming victim to a scam. With little information and a complicated underlying technology, most investors are rightfully very suspicious of this market. However, with time and strong regulation, these concerns can be mitigated.
ICO’s are currently available to only a few firms – those that deal in the domain of blockchain and cryptocurrencies. However, with the pace of innovation in this area, it is conceivable that ICO’s could be an option for many more firms. Another major downside is that currently, this is a very small market. Only an estimated 0.01% of the world holds any cryptocurrency at all. Clearly, this capital market can handle the needs of only a small number of firms. It is also much harder for a company to gauge the amount of capital they will raise as they are dealing with large numbers of small investors compared to the traditional options. A significantly wider adoption of cryptocurrencies is needed to cope with the larger and more consistent demand for capital.